Online Gaming and Stickers: Two More Cabot Emerging Markets teaser stocks

What growth stocks are being teased by Cabot Emerging Markets Investor?

By Travis Johnson, Stock Gumshoe, September 1, 2016

Yesterday I started to look into the stocks teased by Cabot Emerging Markets Investor, and today we’re going to continue on that journey.

If you’re just catching up, you can see that previous note here — the short version is that the Cabot folks see much more upside in emerging markets stocks in the near term, following cash inflows for emerging markets equities in general, and that their number one stock teased was MercadoLibre (MELI), the Latin American ecommerce company.

So now we’ve got numbers two and three on their list to look into and identify for you — let’s get right to it with the first bit of clueishness:

“Our No. 2 Emerging Markets Stock is a fast-growing company that continues to do a very good business in the general internet space in China. The real growth driver these days, accounting for 76% of total revenues, is its game business. The firm first began building this segment in a big way in the mid 2000s, and today it’s one of the leading PC and mobile game firms in China and the world as a whole.

“The stock is up 74% in the last 12 months and is on target to bring similar gains in the months to come as the company increases it online presence and mobile gaming business….

“… the company has crushed most recent analysts earnings estimates by more than 100%.

“Looking ahead, there’s little doubt that demand for online advertising and mobile games will continue to surge in China, bringing double-digit earnings growth to this company. Grab it today to catch its continued momentum.”

That one’s Netease (NTES), which started life as a huge winner with massively multiplayer online role-playing games (MMORPG) in China, where such games are hugely popular (as they are here) — and a few years back, they even in-licensed the most well-known of those games, World of Warcraft, so they run that game in China in addition to a dozen others that they’ve either developed in-house or bought the rights to. They have, as a quick glance at their stock chart will tell you, been hugely successful.

I owned this one probably ten years ago and sold primarily because I couldn’t get myself comfortable with judging which of their games might be hits or misses, but they’ve clearly become a much stronger player over the years since then and have a much more diversified offering of games. Their revenue from PC games has stayed pretty consistent in recent years, but they’ve gotten huge growth from mobile gaming that has led to big income gains (even though mobile gaming generally has lower profit margins than the PC gaming business).

Netease does have some other revenue drivers — they have an online media and portal business, with and news sites and the like, and advertising in those properties also carries nice big margins like gaming but is much smaller (between 5-10% of revenues)… and they have a larger e-commerce, payments, and “virtual goods” business as well, coming in at a little more than 20% of revenues, but with lower gross margins. All three major sectors of the business are growing very quickly and are overwhelmingly domestic (though they do have overseas sales, particularly in gaming).

And, as you might guess for a stock that has been beating earnings estimates and growing earnings at a high rate, the stock is pretty expensive-looking. That’s no surprise, Cabot is a growth investing company and stocks that are growing quickly often look expensive. Right now, NTES is expected to earn a bit of $13 in profits per share for 2016 and $14.37 next year (according to the summary of 17 analysts by Ycharts) — that means, with a share price of about $212, that you’re paying 15 times next year’s earnings for a stock that will be growing earnings at better than 10% a year (again, according to those analysts).

That’s cheaper than the average big US stock, and cheaper than I would have guessed for NTES, though many Chinese stocks trade at discounted levels because of currency or regulatory concerns and I haven’t looked closely enough at the stock today to see if there are any company-specific issues that should be a concern for investors (ie, are some of their games flagging in popularity? Costs rising? New competition taking share? Any accounting shenanigans? Etc., etc), so if you’ve been following the stock and know of any such issues, please let us know.

Based on just the growth expectations and the financial performance, this might be a reasonable buy even at these pretty elevated prices… though the stock has had huge moves up and down, so opportunistic investors might keep an eye out for it the next time the shares take a hit. It doesn’t feel natural to me to buy when stocks are at their highs, but growth investors might find themselves better off (and less psychologically tormented) if they can get used to the fact that buying stocks near all-time highs isn’t necessarily a bad thing, particularly if a stock has been able to make new all-time highs at least every year or two for an extended period of time, as NTES has. And yes, Paul Goodwin of Cabot did also call this one his favorite China stock for 2015, and it’s up about 50% since I wrote about that teaser of his last Summer.

That’s not to say I think you should run off and buy NTES today (I don’t own it, and probably won’t buy it anytime soon) — just that long-term growth investors shouldn’t necessarily reject stocks that look expensive or are at 52-week highs (or all-time highs). The Morningstar analyst puts the current fair value for the stock at $219 because they’ve been able to consolidate leadership in mobile gaming, but she also puts a high degree of uncertainty on that number because of reliance on future blockbuster game development — another big hit game could mean that number is conservative (or vice versa).

What’s next?

“Our No. 3 Emerging Markets Stock is a fast-growing technology opportunity that just had its IPO last month.

“The company’s games, sales of digital stickers and ads were the largest contributors to more than a billion dollars of revenue in 2015 (39% increase over 2014). Revenue growth increased to 62% from the previous quarter.

“Thankfully, few investors know this stock. But that could change quickly as more investors become interested in this technology company. And in a bull market like this, investors have a healthy appetite for new issues. So don’t wait. Grab it now.”

This is the recent IPO Line (LN), which runs the eponymous Japan-based messaging app that was launched by South Korean internet firm Naver several years ago (Line is still a subsidiary of Naver, I believe). Line operates the dominant messaging app in Japan (and Thailand and Indonesia and Taiwan).

The Line app is similar to Facebook’s WhatsApp or Messenger, or to Tencent’s WeChat in China, but it also operates somewhat as a platform (which is clearly Facebook’s ambition with their messaging apps, too) in providing mobile games and entertainment. For a while, a few years ago, the overwhelming portion of their sales were from “stickers” — which are basically emojis that users could buy and send to each other, and that’s obviously a challenged business if there’s any kind of competition, because other companies are happy to offer those for free… but they’re growing less reliant on “sticker” sales and more on advertising and mobile gaming, which are both growing very quickly. It’s a little bit Nintendo-like, with cute cartoon characters that populate their emojis and their games apparently building a strong following among users.

I have not looked very closely at LN, it’s been public for about six weeks now and has started to get a bit of analyst coverage, they have a huge warchest to invest in acquisitions or or expansion (they raised close to a billion dollars in their simultaneous Tokyo/NY IPO), and it’s not terribly clear how they’ll spend that money — but they don’t seem likely to invest heavily in expanding outside of their core markets, since they tried that a couple years ago and it fizzled (and going up against Facebook and WhatsApp in the US and Europe would be expensive — entering China might be profitable, but they’d have to get government approval and try to beat out the entrenched WeChat, and that’s no cakewalk either).

Line claimed 218 million monthly active users at the IPO, most of whom use the service every day, so at a $9 billion market cap that’s roughly $42 per user — there’s no easy standard for how much these kinds of users are worth, a Facebook monthly active user is valued by the market at about $200 (ignoring WhatsApp and Instagram), a Twitter monthly active user is valued at about $44, but $42 doesn’t seem wildly inappropriate if they can continue growing their dominance in Japan and their other core markets, and perhaps increase their presence elsewhere to some degree. Right now, the stock price is almost exactly where it closed on the day of the IPO… so if you find it enticing, well, you haven’t missed much yet. The company reported a profit in their first public quarter, you can see that filing here or their investor relations page here if you’d like to browse for more background. Without having looked much at the historic information or numbers I’m not sure what the context is for their current profitability, and there’s not much in the way of analyst expectations that are clear right now, so there’s probably a fair degree of uncertainty.

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I’d have to do more research to get interested in this stock, but it was the biggest tech IPO of this year, they are profitable and well-funded now, and it will almost certainly get more attention as they get more press coverage and analyst attention in the next couple quarters. If you’ve been following LN or have an opinion to share on that one, please do so with a comment below.

Disclosure: Facebook is a major personal holding. I don’t own any other stocks mentioned above, and will not trade in any stocks covered for at least three days per Stock Gumshoe’s trading rules.


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